You might have heard of bootstrapping as a way of creating a new business, but have you heard of the particular bootstrap effect in M&A? This article will take you through a series of explanations meant to bring you up to speed with an important part of M&A transactions.
What is it?
Bootstrapping, as a standalone concept, represents the process of starting up a new business with little or no money. The term comes from the phrase “pulling oneself up by one’s bootstraps” and it essentially means using internal resources to fund a new venture. This method allows entrepreneurs to have more control over their business, in terms of decisions.
There is another meaning to it however, and it has to do with mergers and acquisitions. Although there is a complex formula for interpreting the outcomes of it, the phenomenon is of high interests for businessmen signing transactions. Therefore, our main focus today is on the specifics of the bootstrap effect in M&A.
So, what is it? The bootstrapping effect is a temporary increase in earnings per share that a company gets when merging, even though the merger has no real economic merit. Moreover, it automatically ensues when the acquirer purchases a business with low P/E, through a stock swap, the end goal being of course increasing the EPS after the acquisition, as well as the stock price.
It is a practice usually found in the corporate finance arena and it should definitely be the object of interest for investors looking to finance a business; but for the sellers trying to be cautious too. They say that devil is in the details and this particular phenomenon is no different. Accountants are playing with it and if you are not careful, the stock price will suffer.
Identifying the bootstrap effect in M&A
This phenomenon also has alternate names – bootstrap earnings effect, EPS bootstrapping – which make the specifics of the whole arrangement easier to grasp. Across the business world and in official documents it will appear under different names, so it is important to know every stand-in term.
But leaving aside the things that are obvious, how can one identify the signs of this bootstrap effect in M&A transactions? Here are a few pointers:
- The shares of the acquirer trade at a higher P/E ratio than shares of the target.
- The acquirer’s EPS increases after the merger without any operational contribution.
The above mentioned tips are the essence of how to identify bootstrapping, but we also recommend this video for further research.
Tied with it are dilutive and accretive mergers. An accretive merger will increase the buying company’s EPS, thus making it similar to the bootstrap effect in M&A transactions, but in a positive way. On the other hand, a dilutive acquisition is a move that decreases the purchasing company’s EPS through negative earnings contribution.
Long-term effects
When talking about the consequences of bootstrapping, you must thoroughly understand them before completing the transaction. Bootstrapping provides only a temporary increase in the stock price and while it is a great outcome, you have to remember it is only short-term. Any upside of this phenomenon will vanish over time. In order to keep the P/E at high numbers, one has to constantly purchase new companies and that is not realistically possible. As a consequence, the stock price will eventually go down.
Although the bootstrap effect in M&A seems like an advantageous outcome of such transactions, in the end it still is only a trick in the accounting department. Therefore, maybe it is not a good idea to hunt only for companies with low P/E, but to focus on others too.
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